Janet Yellen’s Shadow Banking Crisis

We sounded the alarm bells last week. We believe the US Federal Reserve won’t raise rates next month.

The market thinks we’re wrong. According to CME’s FedWatch Tool, there’s a 78.5% chance of a rate lift.

Will it happen?

We should get a better idea this week.

In the US, the latest Fed meeting minutes are due tomorrow. Don’t expect too much of a shock. The minutes should make for positive reading. The Fed has turned a blind eye to the slower economic data. After the 2–3 May meeting, it mentioned ‘…the slowing in growth during the first quarter as likely to be transitory.’

It certainly doesn’t look that way…

April’s US retail spending — on an annual basis — grew at the slowest pace for the year. US inflation data remains below 2% — the Fed’s official target. And global stock markets, as we warned early last week, remain volatile.

There’s lots of time until the next meeting. Janet Yellen could easily get cold feet — only one thing needs to go wrong. Looking at the minutes, it will be interesting to see what she’s assessing to monitor the economic outlook.

Look for the phrase ‘Chinese liquidity issues’. That might sound strange. But the Fed is concerned about international issues. Remember, the Chinese economic slowdown caused a stock market correction early last year. Janet Yellen got scared and didn’t raise rates for an entire year.

That situation could repeat.

Understanding shadow banking

The world is inching closer to a Chinese shadow banking crisis. Shadow banks are non-traditional lending practices. They aren’t bound by tight financial regulation. That’s why they are overleveraged.

Here’s how the system works…

Imagine paying a financial adviser, who works for a shadow bank, $1 million. They invest that money over, say, a 10-year period. The promise is to pay you interest payments each year, with the principal at the end. Other clients come to the ‘bank’ with the same intention. The potential yields are attractive, especially compared to other products from traditional banks.

Everyone is happy. You get a high-yield product. The adviser gets some money to invest into wealth management products…or to lend to other businesses.

Remember, the borrowers are normally higher risk. And they can’t get loans from traditional banks. There are too many regulations to jump through. Chinese traditional banks generally lend only to state-owned enterprises.

Assuming a business wants to build a commercial development project, it would normally go to a shadow bank.

The business model sounds simple…

And it’s easy to see why the Chinese shadow banking sector is out of control. According to various report estimations, the shadow banking system is worth about US$3–10 trillion.

Now take note of the US$7 trillion range in this estimate. That’s how large…and murky…the Chinese shadow banking sector is. And if that doesn’t raise a few warning flags, I’m not sure what will!

WMPs have surged to US$4 trillion in assets over the last few years. That might not seem like much in today’s world. However, multiple defaults emerged around the world prior to the failure of US investment bank Bear Stearns in March 2008. At the time, the asset/liability mismatch was 2% when compared to the total banking system. In other words, when the crisis started to erupt and people wanted their money back, there was a funding shortfall of about 2%. That was enough to send the system crashing.

In China, with US$4 trillion in total WMPs outstanding, the asset/liability mismatch is above 10%. And the size of China’s entire banking system is roughly $34 trillion. Bass has a right to be concerned.

The cracks are starting to show…

The signs of a shadow banking crisis loom

CNBC reported a few weeks back:

‘The disappearance of 3 billion yuan (US$436 million) from China Minsheng Bank’s private banking accounts has once again highlighted Chinese banks’ weak internal controls and the risks associated with the sale of so-called “innovative” wealth-management products on the mainland.

‘An accidental inquiry from an investor exposed the fact that the WMPs sold by a Minsheng branch didn’t even exist. When shocked investors rushed to the bank, they found the head of the branch had been taken into police custody and the supposed due payment date had passed.

‘Investors are still waiting for compensation as well as a detailed explanation from the bank.

‘“If we can’t even trust a big national bank, what other financial institutions can we trust?” Liu Min, who bought 12 million yuan worth of WMPs from Minsheng, said as he waited in the lobby of the Hangtianqiao branch of Minsheng Bank to hear news. Two million yuan of the WMP he invested in is was “due” April 17 but he can’t get the money back.’

Confidence in the system is starting to wear thin…

Foresea Life — one of China’s largest insurers — made a dire warning last week. Bloomberg reported on 18 May (my emphasis added):

‘Foresea Life is warning of mass defaults and social unrest unless the nation’s insurance regulator lifts that new-policy sale ban, according to a letter seen by the Financial Times. The unit of conglomerate Baoneng Group said it expects 60 billion yuan ($8.7 billion) in redemptions this year and might not be able to meet payouts unless it can sell fresh policies.’

The China Insurance Regulatory Commission (CIRC) banned the company from selling all universal life products for three months last year. That ban has expired. And CIRC hasn’t re-issued Foresea Life with a lending licence. Foresea has warned that ‘mass redemptions’ could leave the group unable to meet payouts.

CIRC isn’t bothered…

Instead of re-issuing a licence, three months ago, it barred the company’s director from the industry for a decade.

The regulator imposed a similar three-month ban on insurance company Anbang this month. Anbang’s insurance business has surged over the past five years. Assets have hit US$286 billion — more than triple their 2012 level. The company has financed its operations by selling insurance. However, the focus has been on short-term, high-yielding policies. CIRC accused the group of ‘wreaking havoc’ with its aggressive sales tactics.

It’s clear…

China’s regulator has had enough of the out-of-control WMP market. That shouldn’t be a shock. President Xi Jinping issued a crackdown in the sector to curb financial risk. That’s the right decision. But it could trigger a liquidity crisis very soon.

Lending conditions are tight in China. For that reason, the central bank made its biggest one-day cash injection into the country’s fragile financial markets in nearly four months last week.

A shadow banking crisis looms on the horizon. The Shanghai Composite Index is showing signs it could happen. It’s down about 7% since early April:

This is exactly what happened early last year. Remember, the Shanghai Composite Index nosedived amid liquidity concerns. That ended with the Federal Reserve back-flipping on their interest rate plans for the rest of 2016.

The bottom line: If the Shanghai Composite closes below 3000 points, it could be déjà vu all over again. That could happen if other shadow banks have their lending licence banned. That would trigger a crisis in confidence…and potentially lead to numerous bank runs in the multi-trillion dollar sector.

Regards,

Jason Stevenson,Editor, Markets & Money

PS: If the Chinese stock market keeps dropping, the Aussie stock market should follow it down. That’s what happened early last year. Remember, many economists don’t pay attention to a crisis until it’s too late. Global stock markets are overdue for a 10–15% correction. When the next one starts remains anyone’s guess. But the shadow banking sector could trigger it. And that’s going to lead to multiple opportunities. To find out more, click here.

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